How to invest in private equity

Social media company Twitter has been a good bet for those able to take advantage of its quick doubling in price following its listing on the New York Stock Exchange last November.

But those profits are small when compared to the returns enjoyed by those who bought into Twitter when it was a small private company, such as
Partners Group
, which made 16 times its initial outlay.

Private equity or unlisted equity is an asset class usually reserved for the big end of town – think superannuation, pension and brand name fund managers. The investment horizons are long and the fees can be steep but the double-digit returns produced by the best managers make it all worthwhile.

While the global financial crisis scarred the industry’s reputation as private equity operators floundered with over-geared businesses in challenging economic environments such as the near collapse of
Nine Entertainment
, it would appear that the cycle has finally turned.

A glut of IPOs in the second half of last year resulted in the biggest year for floats since 2007, giving patient ­private equity funds an avenue to realise their investments.

Investors have responded by opening their wallets, with local players such as
Quadrant
closing their seventh fund after raising $850 million and
Pacific Equity Players
expected to close a $2.5 billion fund any day now.

Australian Private Equity and Venture Capital Association (AVCAL) chief executive
Yasser El-Ansary
says the extended investment horizon gives ­private equity funds the flexibility to select assets with better long-term prospects – “businesses that have growth potential even in these very choppy waters here in Australia and right around the world", he says.

Private equity is an investment in real companies that can be valued on the same underlying basis as publicly listed ones. Among its positive attributes are strong returns combined with a low correlation with other asset classes – but the caveats are many and the risks significant.

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Institutions are better placed to absorb the lengthy lock-up periods (up to 10 years) and substantial fees, allocating 2 to 10 per cent of their portfolios to the sector. It can also take several years before private equity managers return capital to investors as they buy and then grow companies before selling – a cycle that produces an ugly J-curve for returns.

Nonetheless, the best managers have continued to perform. A 2011 study of institutional investors published in the Journal of Finance surveyed nearly 1400 US buyout and venture capital funds between 1984 and 2008.

It found significant outperformance against the S&P 500 of around 3 per cent, or 300 basis points, each year over the life of a fund (although riskier venture capital funds, which invest in start-up companies, have under­performed since the 1990s).

“Because private equity investments are illiquid it is, perhaps, not surprising that they yield investors some premium relative to investing in public markets," the study’s authors wrote. “The cost of illiquidity or commitment is likely to vary across investors and remains an important area for research."

The question of liquidity is one of the biggest issue for retail investors, who are also often denied access to the best-performing and in-demand private equity managers. And with the ­potential for higher returns comes higher risk. Many investors and fin­ancial ­planners, such as Hewison ­Private Wealth adviser
Chris Morcom
, remain sceptical.

“I don’t think I’ve ever seen clients make money out of private equity in the retail sector," he says.

A lack of transparency, the investment horizon and the heightened risk of investing in turnaround companies and start-ups pose a near-insurmountable obstacle to retail investors, according to Morcom. He hasn’t gone near the asset class since the early-2000s when a small number of clients had poor returns.

It is something that the private equity industry has attempted to tackle with a number of strategies, with varying degrees of success.

During the mid-2000s, a number of ­private equity funds provided investors with liquidity by listing on the ASX, such as
Macquarie Capital Alliance Group
and
Babcock & Brown Capital
, but the GFC quickly eroded market confidence and the majority were eventually wound up and delisted.

IPE Ltd
is one of the few private equity vehicles from that era still trading and its mature portfolio has been delivering strong returns to investors after several challenging years.

Its $63.6 million portfolio was invested in 60 companies via 16 private equity funds at the end of last year. It returned 5.75¢ in fully-franked dividends in 2013 – a dividend yield of almost 13 per cent at its current share price of about 44¢.

However, future dividends are dependent on ongoing successful sales of the private equity companies in its portfolio, such as Quadrant Private Equity’s ASX listing of retirement village and aged care provider
Summerset Retirement Villages
, which almost tripled its original investment last July.

“Right now it’s trading pretty close to its NAV [net asset value] with a range of promising opportunities in it as well," Schahinger says of IPE Ltd.

Listed private equity vehicles, as with many listed investment companies, often trade at a discount to the value of their assets. They have a smaller pool of investors to draw on compared to most exchange-traded equity funds, which are also composed of more transparent and easier-to-value listed assets.

Blue Sky Alternative Investments
is another ASX-listed player that invests in a range of assets including private equity. It listed in January 2012 and now manages approximately $400 million although it is not a pure private equity play: it is a funds management business that derives income from attracting new capital from investors as well as by investing in its own funds.

The tepid demand in the Australian market for listed private equity differs from the offshore market, which has survived the GFC and is once again growing. Private equity firm
Riverstone Capital
raised more than £760 million to list energy investment vehicle
Riverstone Energy
on the London Stock Exchange (LSE) late last year, says Barwon Investment Management co-founder
Sam Armstrong
.

“The sector is growing because there is a realisation by private equity managers that there are a lot of investors out there that just need liquidity," says Armstrong, who also manages a global listed private equity fund-of-funds.

For example, the LSE-listed ­
JPMorgan Private Equity
recently announced plans to create a liquidating share class, allowing investors to redeem shares at their underlying value, following a strategic review.

“We think that’s a very sensible approach and it’s that more engaged active management by these sorts of funds which means they will ultimately get more support."

Aside from institutional investors, unlisted private equity has typically been the preserve of wealthy clients who are intermittently offered co-­investment deals by investment banks.

It can be an immediate deal-breaker for the average retail investor: while studies consistently show that equity managers’ past performance is no indicator of future performance, there is a correlation in private equity with the best managers consistently remaining at the top of the performance tables.

“Make sure you put your money in the hands of fund managers who have a demonstrable track record of delivering strong results to their investors is perhaps one of the best measures for potential success in the future," AVCAL’s El-Ansary says.

Partners Group, which manages $44 billion globally and counts a number of Australian super funds among its private equity clients, is one of the few major players to bring an institutional offer to the broad retail market.

Nonetheless, it has been a challenging process to educate the market and overcome fears about liquidity, gearing and transparency, according to local managing director
Martin Scott
.

“It’s educating people that this is true investing – investing in a company where you’re doing operational or business improvements to get growth and over the long term this will continue to be a performer in your portfolio."

The Global Value Fund holds more than $430 million in assets globally and, while it underperformed the MSCI World total return index in 2013, its long-term returns remain impressive. Since its May 2007 launch, it has posted a 37.8 per cent net return (measured in euros) against the MSCI World total return index’s 15.4 per cent, at significantly lower volatility.

The fund allows investors to cash out on monthly – up to 20 per cent of the fund’s assets are liquid thanks to cash-producing mezzanine debt investments, ongoing sales of portfolio companies in the secondary market (where companies are sold to other private equity buyers rather than listed on a public stock exchange), and a debt facility (yet to be used, Scott says).

The fund, which has a $20,000 minimum investment, now sits on a number of major investment platforms, such as BT Wrap, after providing more details and assurances to platform trustees that the fund won’t be frozen for an indefinite period in the event of major market dislocation.

“Even through the global financial crisis we didn’t have to gate the fund at all, so generally what we find – even when markets tank – is our fund is performing very well and most people don’t sell what’s performing well," Scott says. “So we didn’t really see that many redemptions through that period."

Investors can access the product at the wholesale investment fee of 1.75 per cent on a number of investment platforms or through Equity Trustees.

However, such offers remain rare even among superannuation platforms where the long-term, illiquid nature of private equity finds a natural home.

For example, AMP SignatureSuper doesn’t offer stand-alone private equity but does offer investment options such as infrastructure (which is similarly illiquid but produces more consistent cash flows) as well as absolute-return funds, which often employ a number of opaque investment strategies.

Many industry super funds remain strong advocates for infrastructure investments but have yet to reopen their private equity programs after disappointing returns through the GFC. (Nonetheless, a working paper published by the Australian Prudential Regulation Authority in 2011 found that not-for-profit super funds earned higher risk-adjusted returns than retail funds because of their higher allocations to illiquid investments such as private equity and real estate.)

Industry fund
HESTA
launched one of the few direct private equity investment options for its members in 2001.

Its investment fee is more than triple the default core pool – 2.52 per cent a year versus 0.80 per cent – although it has performed well, returning an annualised 8.6 per cent (post-fees) a year over the decade ended June 30, 2013 compared with the default core pool’s 7.42 per cent (it attempts to outperform inflation by 7 per cent a year compared to 5 per cent for the share option and 4 per cent for the default option).

It is unlikely to be joined by other super funds offering private equity options in the near term.

Despite their longer investment horizons, super funds have been en­couraged to move to daily unit pricing – a system at odds with quarterly or semi-annual private equity valuations – which could open the door to potential arbitrage opportunities. Funds must also roll over an investor’s money within 30 days of a request under choice-of-fund legislation, further ­complicating matters for any fund seeking to provide investors with an access­ible option.